In this episode of Industry Focus: Energy, Nick Sciple chats with Will Thomson of Massif Capital about the role of ESG investing in addressing climate change.

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This video was recorded on October 29, 2020.

Nick Sciple: Welcome to Industry Focus. I'm Nick Sciple. This week I'm excited to welcome Will Thomson of Massif Capital back to the podcast. Last time we took a look at the coming global energy transition and where potential may lie within that. This time around we'll be discussing how ESG [Environmental, Social, and Corporate Governance] strategies may be starving capital from the industries that are most critical to leading that transition.

Will, thanks again for joining me.

Will Thomson: Thanks for having me, Nick.

Sciple: Great to have you back on. As I said in the intro, we're going to be talking about ESG investing today. I've pulled a couple of numbers just to frame the conversation off the bat. As of the end of second quarter 2020, according to Morningstar, 534 index funds are focused on sustainability overseeing a combined $250 billion in the U.S. That's quadrupled in the past three years the investment in these types of funds. Morgan Stanley said earlier this year that ESG will "define the next decade of investing." Will, you just wrote a paper entitled Failure to Impact: Are ESG Funds Delivering on Investors' Ambitions? Where do you think ESG funds are coming up short today?

Thomson: Well, Nick, there are quite a few places in our opinion, at least. So, the paper, which we'll make available to your listeners, specifically focuses on what ESG ETFs are doing in regards to accomplishing investors' goals as they relate to climate change and the environment. So, one of the things our researchers found, and researchers from third parties, like, The Forum for Sustainable and Responsible Investors [The Forum for Sustainable and Responsible Investment] and Morgan Stanley is that climate change is one of the primary issues for investors, therefore we start ESG and that perhaps more importantly, those investors, the vast majority of them believe that their investments can influence climate change.

We as investors in, sort of, difficult to carbonize industries, that think they have a role in this transition, were quite interested by that. And so, when we dug into it what we found is that if you buy an ESG ETF, you're really not making much of a difference, basically is what it comes down to. The ETF and the way it is structured, the vast majority of the time, you're simply getting an index that is ranked and weighted according to these very odd ESG ranking scores. And that, really, you end up being heavily allocated to companies that are certainly not, sort of, negatively impacting the environment in a significant way, but also, they aren't really making much of a difference.

And so, ESG ETFs and a lot of ESG mutual funds that take a similar approach to integrating ESG into their investment process, which is sort of this scoring that occurs after evaluations taking place, they're mostly allocating to companies like Microsoft, Alphabet, Apple, Walt Disney, these are great businesses, no question about it, but whether they're really promoting, sort of, change in regards to the climate and creating impact is another story altogether.

Sciple: Right. So, it's this idea of avoiding, maybe, companies that emit into the world, but those dollars aren't necessarily directly reducing the amount of emissions being produced?

Thomson: Absolutely. So, I think that as we look out at all the businesses that one can invest in, what one finds is that a lot of the emissions come from these economically critical industries that need to continue to exist in a decarbonized world, whether that be cement or steel manufacturers, whether that is mining companies, and those companies attract no capital in an ESG investment product, and in fact are sort of increasingly potentially becoming starved for capital. And those are the businesses, though, that require investment in order to enable a transition to a low carbon economy.

Sciple: Right. So, you talk in the paper about this idea of two types of firms that fit into that category of companies that aren't getting the capital they need, but they're going to play a role in this transition of the economy, assuming that they're able to, you know, [laughs] get the investment necessary. You break those up into transistors and enablers. What do you mean by those two terms?

Thomson: Right. So, you look at something like a steel company, right? And whether we are a low carbon economy or not, we need infrastructure, we need buildings, you know, both of those things require steel inputs. Manufacturing of all kinds requires steel input. So, steel companies need to continue to exist and they need to transition from their current processes, which are often very carbon intensive to a low-carbon footprint. And that low-carbon footprint may mean that they are powering blast furnaces with hydrogen. There are also other methodologies that people are coming up with, maybe it means more investment in electric arc furnaces powered hydro-power electricity.

Either way, we need steel, but the business needs to transition to a low-carbon footprint. It's not that we can just avoid decarbonizing steel, it's that we need to invest in steel in order to decarbonize it. And investing more in Microsoft or Apple simply isn't going to accomplish that goal.

Sciple: Right. And so, you look at the example maybe of electric vehicles. Massive amounts of capital has flown to that industry, the Tesla and other companies, and you've seen this industry develop in a way that it can really make an impact over this next decade. You don't see that in some of these other industries.

Thomson: Absolutely. As you said, Tesla is sort of one of the great examples. All that capital flowing into Tesla, and Tesla only, basically, you know has changed the direction of the entire industry. You now see every car company -- and just last week, what, GM came out with their electric Hummer. I mean, everyone is turning to electric and a lot of it was driven by capital flows that went into Tesla, and the fear from everyone else that Tesla is going to eat their lunch. So, a lot of people want divestment strategies, they want to not be invested in oil and natural gas, not be invested in steel, not be invested in polluting companies. But the fact of the matter is that smart capital allocation to managers who are thinking about these problems in the long term is going to make a much greater impact on solving the problem than just pulling capital from these businesses and allocating it to, again, businesses that, sort of, neither do harm, nor good. And Tesla is a prime example of that.

Sciple: Yeah. So, you talk about the auto industry, Elon Musk comes in and has turned this into something that people get very excited about. Do we need someone like that in the steel industry, in the cement industry, that makes this a sexy industry to invest in? How much of that is the marketing of some of these industries?

Thomson: [laughs] I mean, I'm not sure how sexy cement can get, but it certainly wouldn't hurt a little marketing acumen on the part of the steel producers, the glass manufacturers would certainly be helpful; chemical industries. The list of industries that are significant emitters just goes on and on. Electricity and the transportation industry, the vast majority of the carbon emissions coming from autos, make up a lot of the emissions, but only about 40% local greenhouse gas emissions. And the rest of it comes from other industries. All those other industries have a Tesla in them somewhere; they have an Elon Musk in them somewhere. Is that person going to be quite as bombastic as Elon Musk? Probably not. But will there be significant returns? Absolutely.

Sciple: So, where do you go about identifying these opportunities, these companies that are on the cutting edge of developing these new processes to make, whether cement production or steel production cleaner? How do you go find these businesses that are doing that?

Thomson: So, we tend to take a bit of, sort of, what we think of as a constraint-based approach. So, we've looked at the IPCC [Intergovernmental Panel on Climate Change] and various different transition pathways. So, how do think-tanks and whatnot believe we need to go on to transition to a low-carbon economy? And in those pathways, they often basically identify, sort of, like a carbon budget. So, we can emit X amount of carbon between now and 2050 to achieve the goal of no more than 1.5 degrees, no more than 2 degrees. And you look at that carbon budget, and you can say, OK, X amount can come from this industry, Y amount can come from this industry. We can sort of divvy it up and say, within this budget, these are the constrained points. There's no capital flowing to steel. There's no capital flowing to glass. There's no capital flowing to, you know, ammonia production methodologies that are low-carbon.

So, within that carbonating budget, we can then identify places where there is an opportunity for someone to either develop a new technology or an opportunity for instituting a new process or an opportunity for something, sort of, out of the right field, like carbon capture, to make a significant impact. And within that, then you look for businesses and you look for management teams that are cognizant of those constraints and are looking for ways to make money by, sort of, breaking through.

And in regards to the transitioners, that is, at least in our mind, one of the better approaches.

Sciple: Yeah, and when it comes to these transitioners, tell me about a company that's in that subsector that you think is interesting right now, and why.

Thomson: So, I think transitioners are -- it's interesting when we look at the landscape, and we'll talk about the enablers in a moment, but, you know, the transitioners and enablers, there's going to be, over the next 30 years, this sort of give-and-take between the two. And at any given time, the path forward, if you will, the path of least resistance for transitioning firms of one kind or another is going to be easier or harder. Right now transitioning firms is a difficult place to look. And the reason for that is because a lot of the technologies, a lot of the business strategies, a lot of the capital allocation that needs to occur is in very early stages. But one of the places where we think it's particularly interesting right now is a lot of, sort of, old-school classic utilities. And specifically, at the moment at least, the European utilities are ahead of the U.S. utilities.

And so, I think for your listeners, who are mostly in the United States, one company that would be interesting to look at, which trades on an ADR with sufficient volume for individual investors, would be something like RWE (OTC:RWEOY), which is a European utility, the ticker symbol and in the U.S. would RWEOY. Now, what's interesting about RWE?

So, RWE is pivoting from being one of Europe's most polluting coal-based electric utilities into the third largest renewable energy producer in Europe, and thus one of the largest in the world, all as a result of this interesting asset swap that they did with E.ON, where they traded assets. And so, what's happening is RWE has this huge pipeline now, they took all of E.ON's renewable assets and gave them a bunch of their transmission assets and a couple of other, sort of, bits-and-pieces here-and-there. And so, now RWE has a giant pipeline of wind and solar, and that is going to result in significant project pipeline growth going forward. There's going to be a premium in the market on what it is they're doing, there's going to be multiple expansions because the earnings quality versus, say, running a coal utility is going to increase. So, there's going to be fundamental based catalysts that drive EPS growth and drive free cash flow growth. And then there's going to be a resulting, sort of, market premium based on multiple expansions.

So, you look at who their competitors are going to be once they finish this transition, which is going to take a couple of years, and it's going to be companies like Orsted or EPD, [Enterprise Products Partners] both of whom trade at significantly higher multiples than RWE. So, I think RWE and other European utilities that are clear on the fact that they are transitioning to renewable power producers as opposed to more traditional utilities that trade as an ADR in the United States are a great opportunity.

Sciple: So, why is the European opportunity, why is that a more attractive market relative to the U.S. right now?

Thomson: Right. And, we kind of see this these days all over the place. So, politics is playing an increasingly important role in everybody's life in everything. And tackling climate change is one of these issues that every time we address a problem, it touches people, it touches businesses, it touches policy and politics. And so, the regulatory role that governments play in the transition and in the industries that are, sort of, the highest polluters is quite high. And the government plays an important role in those industries because they have historically been polluters.

And from a regulatory perspective, the path forward for capital allocation for management teams is much clearer in Europe. When, you know, you go to invest a couple of hundred million to $1 billion in various different projects, you sort of want clarity about what the regulatory regime going forward is going to be. And because there is, sort of, that consistent thought process, or at least a relatively consistent thought process in regards to climate change in Europe, the regulatory environment is much more settled over there for utilities. And it is becoming settled for some of these other industries, and the path forward for some of them is becoming a little clearer also, especially with some of the new regulations and new programs arising out of COVID-related stimulus earlier this year.

Sciple: So, it's much easier to forecast the pathway because that regulatory environment is much clearer?

Thomson: Whether it's easier to forecast or whether it's easier to see, sort of, multiple possible scenarios, I'll leave that up to individuals. We believe it's easier to see some multiple possible positive scenarios in Europe than it is in the United States.

Sciple: While we're talking about utilities, you wrote recently in your most recent investor letter about this conundrum that utilities in the U.S. and other places are facing -- utilities are regulated business, and often on a cost-plus model. What challenges does that present for a company as it transitions more toward renewables?

Thomson: Well, so it's kind of interesting. You know, when you run one of these cost-plus models or you're in a very contentious deregulated utility market in the United States where margins are razor-thin, the marginal cost of production plays an important role in setting the electricity rates. Now, that's the case in any market, of course, but it's particularly vicious in the utility market, if you will. And because renewable power has almost a zero marginal cost, you set up a solar panel and once the solar panel is setup and everything is installed, all you need to really is to sort of keep it clean, there's no additional -- you know, you don't need to buy coal, you don't need to buy natural gas.

So, what ends up happening is the margins just die, there ends up being significant decline, if you will, in the earnings power of the assets unless you continue to grow your base. And so, one of the challenges that utilities in the United States are confronted with is investing in these assets with zero marginal cost and having this cost-plus model while having a fixed customer base. And so, one thing we expect is going to happen in the United States is continued consolidation of the utility industry as they try to properly sequence the buildout of new assets with growth of their customer base, so that they can build out more assets and sort of continue to transition to renewable power.

Sciple: Yes. So, are these businesses going to have to look for new revenue streams, change the nature of the way they earn their dollars? How should we expect these businesses to change?

Thomson: Yeah, no, I absolutely expect that they're going to need to change some of their business models for sure. And we're starting to see some of that in different places already in Europe, less so in the United States, but some of what might be coming is being seen in Europe already, which is, more of a back-and-forth flow of payments between companies and the utilities, whether the companies are producing electricity or whether they are acting as a -- you know, that companies can turn off or run at certain different times of day and be paid for that, and that has value to the utility and there's, sort of, more of a back-and-forth flow. They're also monetizing various different real estate that they have, advertising, things of that nature. So, they're coming up with new ways of making money; electric vehicle chargers, there's all sorts of new things. No one has quite figured it out yet, but there are a lot of companies trying lots of little, sort of, pilot projects all over the place. And so that's still quite unsettled, but that they will need to do something else and do something different is almost certain.

Sciple: Yeah, as you look across the U.S. utility landscape, is there anybody who pops out to you as this is a company who seems to be on the right track or making the right moves?

Thomson: I think AES is particularly interesting, AES is not solely based on the United States, but they are, sort of, a particularly interesting utility. I think they would be one of the opportunities I think that still exists. A couple of the guys, like NextEra, they've already won quite a bit. And AES itself has doubled over the last couple of years. So, there are a couple that have gotten a bit expensive in our opinion. But AES would be one, NextEra would be another.

Sciple: Right. And certainly those, if we're looking at consolidation, they can maybe use that stock price to help carry out some of that.

Thomson: Well, it's certainly a possibility, yeah.

Sciple: So, that's those transitioners, these businesses, like, utilities, steel, cement, businesses that are already in existence that need to make some change to their process or to their business model in order to grow and participate in this energy transition that really needs to happen over these coming decades. When we look at enabler companies, how are those distinguishable from the transitioners?

Thomson: Right. So, obviously, this is a framework we use to think, and so there's a little give-and-take here. Some of the enablers are transitioners themselves and vice versa. But we look at the enablers as sort of the businesses that produce some product that quite literally enables all of these other guys to transition, right? So, Vestas Wind Power, [Vestas Wind Systems] (sic) you know, they build wind turbines, a lot of enablers in our mind are [...] and they transition to a low-carbon economy is incredibly metals-intensive, just in every way, shape, and form.

So, there are a lot of businesses that produce goods that enable others to decarbonize. At the moment, we actually see that enablers is one of the, sort of, largest opportunities in the market. For whatever reason, they're just sort of running ahead of the transitioning firms and the constraints in the system that might result in significant moves upwards in those companies are often based on supply and-demand dynamics that are a little easier to see at the moment than for the transitioning firms.

Sciple: Right. You've got this massive amount of capital flowing into, for example, electric vehicle companies, that requires a significant increase in production of batteries, which requires things like nickel, lithium, etc.

Thomson: Yeah, absolutely. So, you know, I think the numbers for, say, a Tesla car, a 1,000-pound lithium-ion battery, you're looking at, I think it's 25 pounds of lithium, 30 pounds of cobalt, 60 pounds a nickel, 90 pounds of copper, 400 pounds of steel and aluminum. You know, it's a lot of metal that goes into these things. And the same can be said of wind turbines and the same can be said of solar panels.

Sciple: And what is the level of investment in these industries today relative to the needs in the market?

Thomson: Well, it's not enough. So, you look at the mining industry, and I think our most recent statistics for where, sort of, exploration dollars go, I think comes from 2018, and it's something along the lines of 40% of exploration dollars still go to looking for gold mines. I make plenty of money in gold mines, I like gold mines as much as the next guy, but the fact of the matter is that gold doesn't make a difference one way or the other to the transition, whereas finding the next great copper deposit.

You know, we've gotten lucky in the last couple of years, and companies like Ivanhoe and Turquoise Hill (NYSE:TRQ) have found some big deposits in Mongolia and Democratic Republic of Congo, but finding a copper deposit and bringing it to production is very difficult. Nickel, even harder. Lithium, we've got plenty of lithium. Lithium is less challenging, it's more about picking the right company. But graphite is a particularly difficult business also. So, there's a lot of investment that's got to go into these things.

Aluminum, we don't have a lot of shortages or problems finding the inputs into aluminum, but the process of making aluminum is perhaps the most carbon-intensive industrial process that we have on earth, if you will. And yet aluminum is the single metal that is most consistently in all renewable technologies; so, solar panels, for example, the entire frame is made out of aluminum. Cars, increasingly, to sort of lighten their weight, have aluminum in them. Wind turbines, they've got aluminum, it's sort of just everywhere.

Sciple: Sure. So, you talk about this need to increase production of some of these raw materials at a time where it's more and more difficult to find really highly productive mines. As an investor, how do you identify the companies that are going to find these things? Where do you go to look to find these businesses to invest in this opportunity?

Thomson: Well, I mean, the easiest thing to do is to, sort of, pick your commodity first, and then just start listing out the companies that exist on the market. Everyone, especially with mining firms, is going to be comfortable playing in this, sort of, different point in the company's lifecycle. So, you've got junior miners up in Canada that -- you know, they're nothing but geology. If you can assess geology and geological risk, that is a great place in the development curve of mine to play. I would argue that probably most people aren't capable of assessing geological risk.

And we, as largely mining investors, you know, as much as 40% of our portfolio is in mining at any given time, we don't even invest in, sort of, geological plays very often. Only when there's a management team that we really know well and we really can trust, do we do that. That's a very difficult place to play. And if you want to create a portfolio of those types of companies, the answer would be, you need to spend a lot of time doing research and put together a portfolio of probably 20 or 25 of them, it's much more of a, sort of, venture cap game and then it is a consecrated portfolio.

So, you're going to have to be satisfied with the fact that a bunch of them are never going to become anything and you're going to have zeros on those investments. Some of them are going to breakeven, you're going to get your money back, and then a couple of them are going to make all your returns. So, you're not comfortable with that, then you can sort of move over, and these companies all have a bit of a lifecycle in the market, and they, sort of, tend to pop once a geological discovery has been made, and then once everyone, sort of, settles into the fact that this is going to be a 3-, 5-, 10-year process to build a mine, they tend to sell-off again. And down there in that troughs, where there's been significant de-risking and maybe the company has achieved financing already, or they've already got a plan for the mine and construction is under way; you know, significant de-risking has occurred, it becomes more of an engineering and an execution problem. And so, if you've got the skillset to analyze that type of issue, that's a great place to be. And that tends to be where we play.

And you can take a much more concentrated portfolio approach there. And then if you've got none of those skills, you're best off probably looking at, you know, just focusing exclusively on maybe a couple of management teams that you're comfortable with and do you think are trustworthy or heading over to some of the bigger guys at a point in time when they sell-off. The big guys, like a BHP or a Rio Tinto, you know, they cover all the maps. Glencore, heavily invested in all kinds of different transition metals. If you can get them at the right price and you're comfortable just holding them for the long term, they might, sort of, work out well for you.

So, the mining investment space is difficult, but if you are cognizant of what your skillset is, and you're willing to do the work, I don't think any industry more frequently throws up opportunities that could potentially make a lot of money than the mining industry, but the key is, "potentially make a lot of money," so. [laughs]

Sciple: [laughs] Yeah, potentially is doing a lot of work there in that sentence there. So, you talked about, maybe you want to split it off into different commodities of interest. One that I know a lot of people are interested in right now, just because of the electric vehicle space, is lithium. You have some investments in that space. When you look at that area, are there any companies that fall into that second category you mentioned that you find of interest that folks have on their radar?

Thomson: I think our favorite, at least, is Lithium America (NYSE:LAC) or LAC, it trades on NYSE. So, all your American listeners can buy into it easily. They have a deposit in Argentina, a brine deposit, that is going to come online shortly. It's a very large deposit, they've already presold or they have an agreement, if you will, an offtake agreement with Ganfeng, which is Chinese lithium battery producer. So, they presold all the mines' production. And then they have a developing deposit in the United States, actually right near where Elon Musk has [laughs] bought a bunch of property that he thinks he's going to build the lithium mine at, that they will develop over the next couple of years. And once both these deposits are up-and-running, they will be one of the largest producers of lithium in the world.

And it's a very solid management team. One of the things that's tricky about lithium is, and I'm not the one who came up with this, someone else did, so I'm just quoting him. Lithium is more of a chemical business with a mine attached than it is a mining business. So, the actual processing of lithium is quite complex and quite important, and so you need a management team with significant experience. And the LAC management team all comes from Livent, FMC, and Albemarle, which are, sort of, the three big lithium producers who've been in the business of producing lithium for many years and know how to take this rock and turn it to a usable chemical basically.

Sciple: Hey, you mentioned earlier this idea that we actually have a decent amount of lithium, it's that processing and those grades of the metal, is that really the distinguishing factor here?

Thomson: Yes, absolutely. So, no shortage of lithium out there, the question is whether you can take it and turn it into a grade and type of lithium that a particular battery producer wants. And all the battery producers seem to have slightly different -- you know, the broad chemistries are roughly the same, but every producer requires a slightly different tweak, it seems like, to their lithium. And so being able to produce just what that battery producer is looking for is quite important.

Sciple: So, Lithium American, LAC, is one to keep your eye on. As you look at some of these other metals, nickel, copper, aluminum, what are some companies in those categories that maybe jump out to you?

Thomson: Well, in the copper space, for the very intrepid, we still think Turquoise Hill is a fantastic opportunity. TRQ is the ticker symbol. Turquoise Hill has been a bit of a challenged asset. And they are not at production -- well, they've got an open-pit mine in Mongolia. The open-pit mine also has an underground mine that's being developed. The underground mine will come online in the next couple of years. It'll be quite an interesting and unique mine, because of the scale at which they're operating, it's called the block cave mine, it's going to be one of the largest block cave mines in the world. And block cave mining just happens to be a very challenging, sort of, approach to mining.

But that is one of the largest copper deposits with just great grades and great gold byproducts. It's certainly true, it sits there on the Mongolia border with China, so their primary customer is right there buying it right now. You know, I think you're getting it pretty cheap.

There are absolutely risks involved, and there are some political risks involved with Mongolian government. You are partnering, very much so, with Rio Tinto, who owns 51% and, sort of, every six months is rumored to be coming up with some, sort of, scheme to take over the entire company at a discount to its current market cap. Might that come to pass? Sure, it theoretically could. Our bet is that, if they do, you at least get paid a little bit of a premium from here. So, we think Turquoise Hill is interesting.

Another great one is Ivanhoe, which a guy by the name of Robert Friedland discovered the OT mine, which is owned by Rio Tinto. He's also the discoverer of Kamoa-Kakula mine in the Democratic Republic of Congo, which is owned by Ivanhoe. It is just this most spectacular copper deposit I've ever seen. The grades are many multiples of the grades of basically all of your copper deposits around the world. That they will be the lowest cost producer on the cost curve, save for a couple of these copper mines that have these absurd gold byproducts, is absolutely true. That no one can produce the scale, and the scale of copper that they're going to produce at the cost that they're going to produce it at, is almost certain.

Sciple: Yeah. So, given these dynamics that we talked about earlier, I think everybody believes, and you see governments taking steps that will require energy transition, move to renewables, move to electric vehicles, etc., and all these inputs are going to be necessary for that to take place, why are these companies are still a compelling valuation in your view? Like, why hasn't the market realized this? It seems obvious when you lay it out there.

Thomson: No, I mean -- look, you look at something, again, like, Turquoise Hill, Turquoise Hill has had a challenged past. And I think that challenged past, you know, it still weighs on the company. The underground mine is still not up-and-running. That they need to go out and raise some additional capital and will dilute shareholders currently who own it, is certain also. Okay, so there are absolute drawbacks. That everyone, sort of, in the mining space, or a lot of people in the mining space got burned on copper miners and gold miners and iron ore companies within the last five to 10 years is also certainly true.

That in the United States, in particular, ETFs and index investing is driving people toward allocations toward the S&P 500, you know, an index that has no mining companies in it or is driving people to, you know, the QQQs of Nasdaq, you know, that certainly got a role to play. The sort of love affair that we have, and appropriately so at one point, with asset-light software companies. And one time that one was a cheap and fantastic opportunity. Now, at this point, whether those companies are still the fantastic growth opportunity that they once were or are getting a little expensive, I think, is an open question. But all of that, all those flows, if you will, into those businesses, have taken flows away from and attention away from a lot of these real asset businesses.

And so, I think, you know, just a couple of weeks ago, one of the major investment banks in London, you know, they just fired their entire mining team; they just let it go, you know, nobody was interested. Another one, and this is a little more understandable, perhaps, just let go of their entire oil and natural gas team. That there is opportunity and value in some of these businesses due to distraction or lack of interest, is certainly the case. That it may take some time for that to reverse itself is also the case, but because of real-world constraints in, both, sort of, science and physics and the fact that it's great to decarbonize, but software can't do it; you know, it takes a little while for that to filter through and for people to recognize it and to change their way of thinking.

Sciple: Right. Certainly, until these EV markets, etc., etc., to where the demand catches up, it's not going to trickle down to these suppliers.

Thomson: Yeah, I know. Absolutely. I think lithium and cobalt have both had, sort of, a rocky history as of late with a bubble in both that definitely burst. And part of that was driven by, sort of, excitement about EVs and then them not panning out the way people thought they would. Of course, we're not replacing 18 million cars a year with EVs at this early stage isn't surprising. Transitions in the real world are much slower than transitions in the world of software. And so, I actually think there's something interesting going on where we've become quite accustomed during the information revolution, if you will, in the last 20 years to things occurring at these really fast paces.

Of course, when you have real science and engineering challenges, you know, those things don't change quite as quickly. You know, how many miles and how much time do you need to run a car before you're comfortable selling it to the public? Or how much time does a test planned for some new chemical process or energy production methodology need before you are comfortable spending $1 billion building a full scale. Building a mine, you know, a copper mine takes 10 or 15 years to build. So, these transitions are occurring at a pace that is slower and will continue to be slower than people think, in part, because we've gotten so accustomed to transitions occurring so quickly.

Sciple: Right. I mean, you know, it takes a long time to begin with, plus you need the capital to do so. Do you think that this shift of capital flows is pushing back the pace of transition further than it would have been otherwise?

Thomson: To the degree that management teams are looking at, and we all know that they look quarter-to-quarter and we'd like everyone to look sort of long-term, but they don't always do that. And sometimes they are incentivized properly, sometimes they aren't. To the degree that management teams are just looking at their company stock quarter-to-quarter, they're just not going to go out and make big, bold strategic transition decisions or make big, bold capital allocation decisions.

And so, to agree that capital continues to flow away from them rather than into them, yes, it will slow down the transition. That you can say mined copper or mined nickel or produced steel in an economically and environmentally sustainable way -- and they both have to be sustainable, the economics and the environment, they both need to be sustainable, that you can do it is absolutely true, that these companies have the footprints already to do it is less true. So, they need to make large capital allocation decisions. And with large capital allocation decisions, you need a shareholder base who's willing to stick with you, who's willing to look long-term and, sort of, empower management to make these bold decisions, that in the end some of them are not going to work, but some of them are going to be really value creative. It isn't just going to be buying back shares, you know, you're going to create real value that grows the business.

Sciple: Yeah. So, we talked earlier about how access to capital is impacting some of these companies, this year we've seen this huge rise in SPAC [Special-Purpose Acquisition Company] investing as a new way to give capital to companies, particularly it's been late-stage software companies as well as some pre-revenue electric vehicle companies. Do you see that as being an avenue that could solve this funding problem for mining companies?

Thomson: So, there are a couple of rare earth metal SPACs, or at least one that I can think of, that in that particular case, it's an appropriate, sort of, medium to come to market. It seems reasonable -- you know, I can't critique it, if you will. That SPACs represent a potentially interesting path forward for clean energy technologies more broadly, I think is the case. That SPACs have a few issues of their own that we're currently seeing some people resolve by, sort of, not allocating shares to owners as cheaply or sponsors of this package cheaply, as has historically happened is the case, you know, I think is an important part of whether SPACs become a path forward for a lot of these clean energy technologies.

But the historical way that new technologies have been financed, the VC route, is a bit of a difficult route for capital-intensive projects. And a lot of these real asset industries have capital-intensive projects, right? And so, a VC, they want to be able to, sort of, see a path to ramping up, to scaling and to getting out within 10 years. And that timeline has, obviously, gotten extended with things like, Uber and some of these larger companies that have stayed private for longer. But that they want to see a path to getting out and scaling is certainly true. And that's much harder with a real asset industry, that you can, sort of, have a technology and then come to market via a SPAC and have a real significant source of capital, a couple of hundred million right off the bat to build pilot projects that you can show potential customers, is potentially quite value-added. And it's a potentially interesting path for a lot of the early technologies.

Sciple: Certainly. I guess it escapes that VC problem of, you need to be able to see incredible growth and, you know, this idea of Peter Thiel wants to own the entire market. I think you are ever going to own the entire market for a commodity, so a little bit of a different value proposition there.

Thomson: Yeah, absolutely. Very much so.

Sciple: You mentioned rare earths. We see this industry pop up here-and-there, I believe it was a maybe a decade ago was the last time it had super-high interest. Just this month, President Trump planned an Executive Order declaring a national emergency in the mining industry aimed at boosting domestic production of rare earth minerals, reducing dependence on China. What do you make of rare earths? Do you think that this is something that folks should be paying attention to or do you think it's overhyped?

Thomson: I think it's overhyped. One of the things that's quite tricky with commodity businesses and, sort of, understanding the supply and-dynamics is that the size of the industry versus the scale of the producers and what they're capable of producing can create these weird dynamics. So, the rare earth metal market is extremely small. So, the SPAC that is coming online, MP Materials, owns Mountain Pass out in California, which produces neodymium and praseodymium. The total market for those metals is 34,000 kilotons or kilograms a year; must be kilotons.

They're going to produce somewhere between the single mine, when it's fully up-and-running, they're going to produce something between 15% and 20% of the global market. So, they're just going to drop, basically, 20% more supply or 15%, somewhere between those two into the market. And because it's so small, the ability to absorb that new supply as it comes online is quite constrained.

Now, the hope with rare earths, of course, is that electric cars and various electrification technologies grow exponentially and absorbed. But as we've already seen, say, with lithium and cobalt, getting that timing just right is quite difficult, and frankly, it's not that you can get the timing right. You know, a company might get lucky and happen to bring on its mine at just the right time, but that management can foresee with enough clarity that they can sequence bringing it online at just the right time, is just nonsense. That there is a theoretical long-term opportunity in rare earths; I'm willing to absolutely entertain that proposition. That I have yet to see a rare earth mining company that was a continuously profitable and value creative business, I mean, I just haven't seen one.

Now, admittedly there aren't that many, but Lynas Corp, which is in Australia and is, sort of like, the largest publicly traded rare earth miner, if you get your timing just right on the equity side, you'll make some money, because from time-to-time they make money. But the point is that the market is so small, the supply and-demand dynamic so tricky that they only make money some of the time. It's just with highly niche metals that are sold not on open markets but on contract, it's just very tricky to, sort of, get it right at both the operator level and at the equity investor level.

So, MP Materials is the SPAC that's coming online. I think it's interesting. I've read the S-4, the registration documents. You know, it's certainly intriguing. I'm going to keep an eye on it, but I'm certainly not going to buy it here in absence of a lot more information than we currently have coming to us. I'd also just, sort of, add that, in regards to that particular SPAC, there's just some, sort of, interesting dynamics going on there. There is a Chinese owner, and part of the reason that Donald Trump declared an emergency, of course, in rare earths is because China owns so much of the rare earth metal market. So, what role that Chinese owner plays in this company going forward, and I think when the company is public, it's going to own about 10%, you know, is an open question -- or 6% to 10%. So, I think there's some interesting dynamics at play, and it's going to be an interesting process and story to watch that it is investible now, though, I think is probably an open question.

Sciple: Right. So, it's a bigger deal for the markets that it'll be supplying than it is for maybe the people who might potentially invest in the equity of the business?

Thomson: I think so, yes ...

Sciple: And is this one of those high prices solves high prices things? Like, maybe you see in oil, where once that opportunity in rare earth presents itself, you suddenly have folks exploring for the metal and then that floods supply and rinse-repeat?

Thomson: Yeah, I think so. I think that's a good way of putting it. I mean, I think that's a pretty common, sort of, path for a lot of markets; that, sort of, capital cycle analysis, if you will, that people will flood markets when there's an opportunity to make money. And then, because they flood the market, the money to be made will, sort of, decline, margins will decline. You see that at play in almost all commodities, but it just goes into hyper-overdrive, if you will, when the market is so very small.

Sciple: So, that raises a question for me now. We've talked about this point in time where there's clearly growth in the end markets for some of these commodities, but they're starved for capital. Do you see this as, you know, where we're at the beginning of what could be a new cycle? And if so, you know, how long do these cycles typically run?

Thomson: That we are at the early stage of a potentially positive cycle for a lot of these metals, I think is true, is it -- you know, 10 years ago you heard people talking, that's a commodity super-cycle, and things of that nature. There's a commodity super-cycle -- yeah, I'm not going to make that claim, that we're entering a good environment, which is all you really need, for metals like copper, lithium, or nickel over the next 10 to 20 years? I think that's absolutely true. That they can last 10, 20 or 30 years? I think it is absolutely true in this case also. You just look at, sort of, how long it's going to take to replace a lot of existing assets, especially on the EV side. It's going to take a long time. It's not going to be -- you know, you're not going to get a pop, make a bunch of money by investing in Tesla right now, and then go away and never make money again. You know, there are going to be opportunities that come up over and over and over again over the next 10 to 20 years in some of these, sort of, enablers of the transition.

Sciple: We talked earlier about this idea that ESG funds are leading to capital being starved from these industries that are really going to be most important to reducing emissions going into the future and transitioning our economy to a cleaner energy infrastructure. What advice do you have for retail investors who want to make those types of impactful investments in the economy given those limitations of ESG funds?

Thomson: So, I would, again, emphasize looking at the world of carbon emissions in a bit of constraint-based framework. Look for those pinch points, look for the places where there is a lot of carbon emissions, a lot of greenhouse gas emissions and no one is trying to address the problem and/or the solutions to the problems are not attracting any attention. Right.

So, you know, everybody is looking at the auto industry right now. That there will be money made, that is absolutely certain, but that you, the individual sitting there doing research on your own is going to find the next great opportunity is probably unlikely with all the eyes that are on it. So, you know, look to some of those out of the way industries that feed into solving the problems in some of the industries that aren't attracting the attention, so the steel industry, the cement industry, the glass industry.

You know, the chemical industry is a huge carbon emitter, and we use chemicals everywhere, chemicals aren't going anywhere. Everyone needs paints, and laminants, and glues, and sealants. These things, you know, I look at my desk and every product has some sort of chemical in it somewhere in some way. You know, how are those industries going to decarbonize, where are the opportunities in those industries, where are the constraints that are preventing the transition, and who is looking at addressing those constraints. That would be my advice. It takes forever, but good investing always does.

Sciple: Absolutely. These are the folks who -- there's not a lot of people competing in those industries where there may be some opportunities.

Will, thanks again for joining us on the podcast, as this continues to play out, we'd love to have you back on again to talk about some other opportunities to invest in.

Thomson: Absolutely, I'd love to do so.

Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear.

Thanks to Steve Broido for mixing the show. For Will Thomson, I'm Nick Sciple, thanks for listening and Fool on!

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.